Long-term success with investing requires a deep understanding of the business we want to buy BEFORE we buy them. It’s what the best investors in the world do and It’s what sets us apart from the other investors out there.
This is also why they (the Next Level Investing Guru’s; AKA NLIG’s), have extremely concentrated portfolios. If instead the NLIG’s diversified, you know, the way a financial advisor would likely recommend (100+ stocks) then how could they possibly understand each company they own?
If we can’t understand what we own, how could we ever know when a company is underpriced or overpriced?
In other words, without putting in the upfront legwork, how in the heck are you supposed to know when it’s time to buy and when it’s time to sell?! You wouldn’t. Simple as that.
To ensure they understand what they own, NLIG’s build a narrative around a business they’re looking to invest in. They know and understand how the business operates before they buy. With this background knowledge they are prepared if & when news comes out about the business, good or bad, and are ready to adjust their investment appropriately.
They understand If it’s a short-term issue, likely creating a buying opportunity, to buy more! And they are able to figure out if it’s detrimental to the business, and should instead change their narrative, and sell out of the position.
You can quickly see why this is so important, right? All of this structure and decision making can’t exist without the initial work they put in to create that their narrative.
Without this upfront effort, you are guessing not investing. You are gambing your money away, Hoping the stock price moves up from the price you bought in at instead of being certain that the downside risk is extremely limited.
Without any actual knowledge of a business/stock you are buying, how is that not gambling?
“Investing without doing the research is like playing Poker all night, without ever actually looking at your cards.”
~Robert Hagstrom~
This upfront work is what sets us apart from the vast majority of people in the stock market. Just ask a couple simple questions to one of your co-workers or acquaintances that you know ‘invests’ in the stock market. Or try joining almost any investing Facebook Group. You’ll quickly find that almost nobody out there actually does the work. If we want to do better, we need to be different.
Building your Narrative
In Part 1 we found out that Pabrai recently purchased a large amount of GrafTech (Ticker: EAF). Mohnish buying a business is enough to get me curious, so I’ve started to really dig into this one.
The first thing we need to figure out is if this business is in our wheelhouse. Warren Buffett calls this our ‘Circle of Competence’. Buffett asks;
“Are we Capable of understanding the business?”.
This process should be fun! Don’t worry if a business someone else is looking into isn’t in your wheelhouse. The more practice you put into this style of investing, the wider your Competency Circle becomes. The key is to STAY in your circle, know where it’s edges are, and don’t even step one foot outside that circle.
This is arguably one of the main reasons why Warren Buffett has had such an amazing track record; He is steadfast in staying inside his Competency Circle.
In fact, Buffett loves putting businesses onto his ‘too hard’ pile that is literally on his desk; The faster he can do that, the quicker he can drop a company into the ‘top hard’ pile, the faster he is able to move onto an exceptional investment opportunity that’s inside his circle.
Next Level Sidenote (NLSn): Remember what I said last time? We want to say NO to the company we’re studying as quickly as we can. One way to do this is with the ‘Eye Gloss test’. (Don’t worry, it’s an easy test…) If you are diving into a business and find your eyes glossing over, either from boredom or from trying to understand just what the heck they do, then the company is probably not in your Competency Circle.
This is always good news. The quicker you can move on, the better. We don’t need to waste time on a company we don’t understand or isn’t interesting to us.
Ignore your ego on this. Just because someone else thinks it’s a great investment, doesn’t mean it’s a good one for you. I guarantee there is an area of the market your an expert in, and you probably don’t even know it. When you find the business in your ‘Knowledge Niche’, you’ll know it. You’ll find yourself deeply interested in how the business operates, and you’ll also notice how easily you seem to understand exactly how they operate.
We must be able to figure out exactly What they do, Who they serve, and just how well they operate. We then need to put all of this together to figure out exactly how much downside we have on this company. If the risk is too high, we wait until the price is low enough to all but eliminate that risk.
In other words, While other investors are licking their lips with what they could make on an investment, we focus intensely on what we have to lose.
Focus on the downside & the upside will take care of itself.
GrafTech (EAF) Narrative
It’s time to build our narrative around GrafTech. We’ll answer some important questions and decide whether or not we think this business falls within our Competency Circle. Let’s start where we ended; With Mohnish Pabrai.
If you listened to his interview with MOI Global (which you definitely should have by now…). He mentions that for Graftech, the next 3-5 years of cash flow are all but guaranteed thanks to the type of contracts they have set-up with their clients.
These contracts are called Take or Pay, which means that they negotiate a certain amount of product at a certain price over a certain period of time. The client can then either take what they agreed to, paying the agreed upon amount, or decide not to take the product and instead Pay a certain amount and receive no product.
Pabrai mentioned that the Cash Flow of GrafTech over these next 4-5 years is almost equal to the current market cap (currently sitting at around $3.4B)
In other words, if you were able to buy the entire company right now for what’s it’s being offered for on the stock market, your entire investment would be completely paid off over the next 5 years. In other words, this appears to be another one of Pabrai’s classic ‘PE of 1’ investments.
He goes on to mention that he’s not exactly sure what the company is worth, but he knows where the floor is, and he’s bought in below that. Said another way, he believes that there is very little downside risk at his purchase price of $11.50, with a lot of upside potential. Sweet.
Summarize the Narrative
Alright so, good news! We already have the narrative we’re looking to uncover/disprove with our research.
If we can buy GrafTech at or below $11.50, in 5 years we will essentially have a free lottery ticket due to the generation of cash flow over that period. This Cash flow is all but guaranteed thanks to long-term take or pay contracts GrafTech has set up with it’s customers. This likely puts a value floor on the price of the stock due to this cash generation. If the stock goes down below $11.50 further shrinking our ‘CashBack’ period and creating a larger cash flow yield on the stock, this will attract buyers until a more reasonable valuation is reached.
Currently the business is sitting at a PE of close to 4. Over the next 4-5 years with Pabrai’s purchase price, this will become a ‘PE of 1’ investment.
Bull case: after these 3-5 year contracts are fulfilled, they will rinse and repeat following the same method and generating more cash flow, essentially becoming an extremely cash rich business (Profit Margin currently sitting at 42%). Due to the nature of these long-term take or pay contracts, it’s very easy to predict the next 4-5 years of cash generation, earnings, etc. In fact, right now the take-or-pay contracts total 675,000 metric tons from 2018 through 2023 (we’ll run the math on this later).
NLSn: Essentially, our narrative is our North Star. It’s what we always come back to when we read/hear/see any news about a company we’ve invested in.
The Narrative is the main reason we invested in a business, and it’s the driving force for our belief that this may in fact be, an excellent investment. In other words, everything new we learn about the company, we add, subtract, or adjust our Narrative accordingly. Don’t forget; We are aspiring NLI’s must remain rational. If our Narrative is permanently damaged, we must change our thesis and act accordingly.
GraphTech International:
What the heck do they do?
GrafTech is a leading manufacturer of high quality graphite electrode products essential to the production of electric arc furnaces (which is why GraphTech went with the Ticker EAF, short for Electric Arc Furnace).
The Company has a competitive portfolio of low-cost graphite electrode manufacturing facilities, including three of the highest capacity facilities in the world.
GrafTech is also the only large scale graphite electrode producer that is substantially vertically integrated into petroleum needle coke, the primary raw material for graphite electrode manufacturing, (which is currently in limited supply).
This unique position provides competitive advantages in both product quality and cost.
It’s always nice when the company describes one of their competitive advantages right in the bio. It makes our job a whole lot easier… But we’ll visit this idea again in greater detail in Part 4.
To summarize in plain english for you… (I Hope) GrafTech supplies steelmakers (those which use a specific type of smelting process; electric arc furnaces) with an essential consumable item for smelting; Graphite Electrodes. These are consumable in that they are literally ‘Consumed’ after so many uses. In other words, the more they are used the more they breakdown and have to be replaced. This means that steelmakers need Graphite Electrodes in order to produce.
As It turns out, these graphite electrodes are a very small overall cost to the steel producers, accounting for only 3-5% of their total production costs.
This makes any swing in the market prices of graphite electrodes much more trivial compared to, for example, any changes in the price for steel scrap itself, which makes up roughly 68% of total costs for steel producers.
This is good news for GrafTech. Not only are they supplying something that is essential for production and constantly depleted, but the cost for the consumer is trivial compared to other material costs. Cool beans.
Now that we know exactly what they do, we want to find out how they plan on generating all the cash flow Pabrai mentioned in his interview.
GrafTech’s Cash Flow
If we look at the most recent Quarterly Report (10Q), we find they have 675,000 tons of electrodes already agreed upon with long-term (3-5 year) Take or pay contracts. These contracts are locked in at prices that give them a very healthy profit margin, selling their goods for an average price of $9,700 Per ton over the next 4-5 years.
These contracts are likely a win-win for Graftech and their customers. It allows the customer the flexibility to plan ahead for their material costs, and GrafTech is happy with their Margins on the price they are locking these contracts in at.
It may help to think of this in terms of a farmer locking in seed prices for the next few seasons. The buyer understands that If they can lock in their cost of Seed at a certain price, they are likely to do better than break-even if the crop is at all descent, and not lose much if the crop does poorly (sound familiar?).
GrafTechs customers know they can be profitable at these prices, and they need a reliable source for the product so they lock in long-term contracts. It also allows them to ignore the market price fluctuations in Graphite Electrodes. This is just me speculating, but it makes sense.
Apparently, only Graftech (according to GraphTech...) is able to offer this type of contract to their customers. This is due to their vertical integration on a crucial ingredient required to create these graphite electrodes; Needle Coke (I don’t know what this is yet except it’s the main ingredient in their electrodes.).
This Vertical integration piece just means that they supply a large amount (roughly two-thirds) of their own materials to make their finished product. This is a big deal because it gives them both pricing flexibility, and larger profit margins. It also protects/hedges them from an increase in cost of raw materials, since they supply over two-thirds of their own raw material needs. Sweet.
Other Graphite Electrode manufacturers are getting hit much harder by the increase in cost of raw materials. Needle coke has seen a gradual, but quick increase in price due to the higher demand of Lithium batteries. The main ingredient for these batteries is, you guessed it, needle coke.
GraphTech has a compelling business model. The vertical integration of their raw material is a big check in the plus column for me. As mentioned above, needle coke is in high demand these days, so it’s a big advantage for them to be able to supply two-thirds of their raw materials and only having one third exposed to market pricing for needle coke.
GrafTechs output, by the way, appears to be in the area of around 180,000 - 200,000 tons a year when operating at close to 100%.
Another interesting aspect that GraphTech has going for it is just how geographically diversified their contracts are. According to Q2, contracts are spread over 100 customers all over the world, giving them some diversification and possible protection from recessions &/or market disruptions at a smaller geographical level.
I also got the sense that they plan to finalize some details on more contracts this fall, which we should hear about in their next earnings call (Q3), but for that we’ll have to wait and see (but not long, they release earnings on November 7th).
Fun With Numbers
I know that the heading seems like a bit of an oxymoron, but this is really where we make our money, it’s in the numbers, and making money is really fun!
Let’s start with the Cash Flows we know about; The long-term contracts.
They have contracted 675,000 MT at an average price of $9,700 over the next 5 years.
This should generate $6,547,500,000. That's a little over $6.54 Billion, or roughly $1.31 Billion a year.
Based on Q2 earnings, they retain about half of that as earnings, and roughly a third as Free Cash Flow (FCF). You can tell this is napkin math, but it’s always better to be roughly right rather than precisely wrong…
This works out to $436 Million in FCF a year. Remember that all this is only calculated based on the contracts. What we now know (thanks to our research) is that they have a total production capacity of about 180,000 tons of electrodes on the low end. If they manage to sell all they produce, for the same price as the contracts (which is being conservative with today's prices) that totals $1.746 Billion in revenue. Multiply that by a third and we get our Free Cash Flow for one year at $582 Million. It’s likely going to be closer to $660 Million based on their current earnings (projecting from close to $330 million after two quarters), but being conservative in our estimates is always a good idea. Let’s round up to $600 million just to make our math lives easy.
If we simply multiply our yearly long-term contracted Free Cash Flow, which is the most reliable number, by 5, then we get to $2.18 Billion. That’s cash and the all but guaranteed amount.
If we add in the less guaranteed capacity, and assume the average long-term price we get roughly $3.3 Billion in Free Cash Flow over the next 5 years.
As of this writing, the stock price for GrafTech (Ticker EAF) is $11.36 and the Market Cap is sitting at $3.30 Billion. That’s a fun coincidence isn’t it?! I swear that wasn’t planned... But it all but proves our theory of why Pabrai bought this stock. The entire cost of the company based on what the stock market is offering it for today (the market cap) is back in the owners pockets in just 5 years. Nice!
Fun Facts
The prices for what GrafTech charges for Graphite Electrodes has rapidly increased since 2017. In fact, electrodes were sold for between $2000-$3000 a ton at that time. Today GraphTech is locking in long-term prices at $9,700, with their short-term contracts averaging even higher prices.
There are multiple explanations for why the price increased so rapidly: The most common is due to the raw material needed to make Graphite electrodes; Needle Coke, becoming short in supply and high in demand.
This is in part due to more Electric Arc Furnaces coming online and also the growth of electric vehicles (both of which are expected to grow & therefore require more raw materials in the future, further driving up prices).
The second point may seem strange, but it turns out that high grade needle coke is the primary ingredient in lithium batteries. With GrafTechs vertical integration of the primary ingredient; Needle Coke, this is likely where they are getting their large Profit Margins.
The question we need to ask/answer is: Is this a new normal for prices? Or, is there a risk of prices falling back to where they were in 2017. This is something we’ll be diving into in Part 6: Reverse the Narrative.
Focus on the Downside
With any business we’re looking to purchase, we should want them to have low to Zero debt. Trust me when I say ‘Debt Kills’. It’s like an anchor dragging at the bottom of the sea, holding the business back from truly sailing. If there is any sort of snag along the journey, it can bring a dead stop to the business, and after that, it won’t take long before the sharks begin to circle...
This is the reason why a company with zero debt has a big advantage over the competition. They don’t have an anchor holding them back; they are free to sail off into the sunset. Those are the ships we want to be on.
You can see why Next Level Investors prefer to buy companies with Zero Debt. This should always be the standard we strive for and compare against.
However, if it can’t be avoided, then we should only invest in businesses that have a small amount of debt, and can pay it off in 5 years or less with their Free Cash Flow. We should also be able to find that they have a plan in place to do so.
With all else being equal; the lower the debt, the lower downside risk, the stronger the business.
Seriously, Debt kills. Pay attention to it.
Red Flag
Debt is the biggest red flag I have found with GrafTech. They have roughly $2 Billion in long-term Debt. Just servicing this level of debt is very expensive. Costing them around $132 million each year in interest payments alone. Ouch.
Based on what I’ve read thus far, it seems management is focused on reducing their debt burden by a large amount. They mention in the 2018 annual report that they paid down $125 million of debt in the first quarter of 2019, and plan to pay down similar amounts of debt in future quarters (subject to board approval).
However, if you read the Q2 report, they have paid down a total of $125 million after 6 months. My guess is they see more value in stock buybacks at current stock prices, so they are currently focused on returning value to the shareholders through this vehicle for now instead of an accelerated debt repayment. I do still expect to see their debt being further reduced in the second half of 2019.
It’s important to note that GrafTech has revolving debt of around $250 million, so we should expect that amount to stay on their Balance Sheet going forward.
In my opinion, the faster they are able to pay off their debt the better. Remember, as soon as we purchase any shares in a business we become owners. This means that when we buy, we buy everything the company has; It’s cash flows, earnings, and its debt.
Looking forward by looking backward...
If we look at their last twelve months, we see that GrafTech actually managed to generate $749 million in FCF. In that time they used 24%, or $181 million of Free Cash Flow to pay down debt, 70% of that FCF was returned to shareholders in the form of dividends, share repurchases, and special, one time dividends.
(GrafTech Q2 Earnings presentation 2019)
The good news for shareholders, other than them paying off their debt, is they seem to be shareholder oriented. This may be helped by their majority shareholder Brookfield Energy, who likely has a lot of sway over what the company does. This can be good or bad. So far from what I’m reading, they seem to be doing well with taking the company in the right direction.
GrafTech has already confirmed an allocation of up to $100 million in share repurchases over the second half of this year. They claim that this is roughly 15 percent of the share float at today’s stock price. This means that anyone who owns a share of GrafTech will see their ownership percentage grow by 15%.
They also state their plan to return 50-60% of future cash flow to shareholders in some form. They are doing this in multiple ways:
Quarterly dividend of roughly $25 Million ($100 million yearly).
Board approved share buyback of $100 million or 15% of float (based on share price of $11.16).
This leaves $160 million to be given to shareholders in some other form yet to be divulged.
All of these avenues will return cash to shareholders either directly through dividends, or indirectly through share repurchases. Either way, this is good news for those who have shares in GrafTech.
If we apply these same conservative number over the next five years, we can see a significant decrease in our capital at risk.
Remember, we pay special attention to risk not return. The more capital that is returned to us, the lower our investment risk.
Reducing Risk over the next five years
Note: all numbers are calculated in a ‘per share basis’. It’s just easier to visualize that way. Keep in mind that these are mostly guaranteed returns over the next 5 years. We’ll have to wait and see what the next Quarterly report tells us about any further adds to long-term contracts (which takes place on November 7th).
$500 million in quarterly dividend. ($1.89 paid back to shareholders)
$500 million in share repurchases (over 43.5 million shares at $11.50 reducing share count by 15%)
$800 million in unannounced return of capital to shareholders (if we assume a special dividend, they will pay out another $3.03)
Total = $1.8 Billion
Total Dividends = $4.93
Total Share reduction of 15% (you can then sell 15% of your shares to equal same ownership as before repurchases).
Share Repurchase value = $1.73
Total risk reduction/return of capital = $6.65
Assumed purchase price of $11.50
New Cost basis after 5 years = $4.85
Total Return of Capital = 58%
BONUS:
‘Next Level Dividend’ Returns = $0.90 (yearly)
Total return over 5 years = $4.50
New Cost Basis = $0.35
Total return of Capital = 97%
Total risk remaining = 3%
Summary
Right now I’d say this company is turning out to be very interesting. For me the key is the vertical integration. This is a huge advantage, and it lowers their market risk by a large amount going forward. The other big plus is their long-term contracts. It makes it extremely easy for us to see exactly what these next few years are going to be like. The easier it is for us to figure out, the better.
The next big step is Part 3: GrafTechs’ Management. We need to take is to discover exactly who is running this ship, and we do that by figuring out as much as we can about the leadership of this company.
It definitely won’t be as meaty as this one, but it’s just as important. Stay tuned.
Before you go, don’t forget to grab your Free Investing Guide. It shows you the exact 7 Step Investing Process I use to find great investment opportunities!
~Ryan Chudyk~
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